Understanding Amortization and How the Mortgage Loan is Paid Down (and Off)

Understanding Amortization and How the Mortgage Loan is Paid Down (and Off)

Before purchasing a home it is important to review and understand mortgage amortization or how your mortgage loan will amortize.

If you have recently started looking for a home or researching the mortgage industry, you have probably heard the term “amortization” more than just a few times. The word sounds fancy, but it involves a very simple concept. Here is a brief discussion about what amortization means so you can have a better idea about what lenders and mortgage professionals are saying when they use that word.

  • In basic terms, amortization or mortgage amortization refers to reduction in the principal balance of the loan over time due to payments allocated to principal (as opposed to allocated to mortgage interest or to “servicing” the mortgage) on a fixed schedule.
  • The word “amortization” is derived from the Latin root “mors,” which literally means “to die.” So you can think of amortization as “killing” your mortgage loan over time through scheduled payments.
  • At some point, your mortgagor will present you with an amortization schedule.  This schedule demonstrates how much of each mortgage payment will be applied to the interest on the loan and how much is applied to the principle of the loan – or, to amortizing the loan.  An amortization schedule will ordinarily show that where you have a constant interest payment, a greater part of each payment over time will be allocated to amortization of principal than in the month before.  Comparing amortization schedules for different loans (ie., for a 15 year mortgage versus a 30 year mortgage) will demonstrate that greater amounts of each payment are allocated to amortization in the shorter duration mortgage as the mortgage needs to be killed more quickly.  Comparing amortization schedules can also help you to understand the interest rate risks involved in Adjustable Rate Mortgages (ARMs).
  • Interest-only mortgage loans are, by their very nature, loans that are non-amortizing for a certain period.  An interest-only loan has a non-amortizing period (or could even have a negative amortizing period where the mortgage balance increases) for the first few years or even first half of the loan term.  This period is then followed by an amortizing loan in which the borrower amortizes the principal more quickly.   Lenders, in principle, like making interest-only mortgages because they increase the principal mortgage balance remains outstanding at its highest principal value for a long period of time, enabling the bank to maximize the mortgage interest that it is receiving.  However, homeowners, should be seeking to amortize or gradually kill off a mortgage and gain equity in their homes.  Many borrowers in the 2000’s got into a lot of trouble by using interest-only mortgages to borrow amounts on homes that they would not have been able to afford if they were required to take out an amortizing mortgage and have part of their monthly payment allocated to killing the principal at the time of their home purchases.  

These are just a few facts to help you understand what amortizing is and what mortgage professionals mean when they use the term. Hopefully this will help you be more informed during your home buying experience so you can make a well-educated decision about the terms of your mortgage loan.

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Reviews

  • Evan

    July 19, 2011

    It amazes me that people do not understand this when they refinance. If you have a 30 year loan and have paid off ten years, and then refinance back to a new 3 year loan, you are starting the amortization all over again. That means you are have reset the clock and are paying mostly all interest for the next 10 years. That's why it's important to consider amortization when calculating the economic advantage of refinancing. Most people just look at the lower payment and don't realize over the long run they are making themselves equity poor.

    A no interest loan is even worse. You might as well rent.

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